Professional Documents
Culture Documents
Chapter 1
Introduction to Islamic Banking:
Islamic banking is a new phenomenon that has taken many
observers by surprise. Islamic banking (also called non-interest based,
Riba or interest free banking) is an alternate to interest based banking. Its
inspirations and guidance is derived from the directives of Shariah and has
to be conducted rigorously in accordance with these directions. The key
feature of Islamic banking is the prohibition of Riba. Islamic banking is a
system of banking, which is based on Shariah rules and principles. It is
different from current banking system, which is based on Riba. Islamic
baking is based on profit and loss sharing.
Shariah Principles
In the seventies, changes took place in the political climate of
many Muslim countries so that there was no longer any strong need to
establish Islamic financial institutions under cover. A number of Islamic
banks, both in letter and spirit, came into existence in the Middle East,
e.g., the Dubai Islamic Bank (l975), the Faisal Islamic Bank of Sudan
(l977), the Faisal Islamic Bank of Egypt (l977), and the Bahrain Islamic
Bank (l979), to mention a few. The Asia-Pacific region was not oblivious
to the winds of change. The Philippine Amanah Bank (PAB) was
established in l973 by Presidential Decree as a specialized banking
institution without reference to its Islamic character in the bank's charter.
The establishment of the PAB was a response by the Philippines
Government to the Muslim rebellion in the south, designed to serve the
special banking needs of the Muslim community. However, the primary
task of the PAB was to assist rehabilitation and reconstruction in
Mindanao, Sulu and Palawan in the south (Mastura l988). The PAB has
eight branches located in the major cities of the southern Muslim
provinces, including one in Makati (Metro Manila), in addition to the head
office located at Zamboanga City in Mindanao. The PAB, however, is not
strictly an Islamic bank, since interest-based operations continue to coexist
with the Islamic modes of financing. It is indeed fascinating to observe
that the PAB operates two 'windows' for deposit transactions, i.e.,
building in this regard is one of the top most priorities for the promotion of
Islamic Banking. In order to play our regulatory and supervisory role more
efficiently we are working on the areas like Risk Management, Corporate
Governance, Prudential Regulations, Accounting and Shariah Standards
etc. regarding Islamic Banking
Currently the Islamic Banking Department (IBD) consists of
following three divisions:
1. Policy Division
2. Shariah Compliance Division
3. Business Support Division
The conventional banks in Pakistan have 31 dedicated Islamic
banking branches and there is increasing interest from these entities to
open branches. With the new applications for full-fledged Islamic banks
show the promising growth. The State Bank of Pakistan expects the
number of total dedicated Islamic branches to grow substantially by end
December 2006.
According to an analyst with the regular entrance of new
Islamic Banks, the market stands to benefit and grow. The injection of new
ideas, the investment in training and infrastructure, and the healthy results
that free competition engenders all coming together within a properly
regulated and risk management environment. "Though the Pakistani
market presents its own unique set of challenges amidst a dynamic and
competitive arena, it truly presents the fitting crucible for the evolution of
Islamic banking in its most cogent form".
Meezan Bank, the country's premier Islamic bank said in its
recently released report that soon the "smart branch", though not new
concept would be launched. The concept of self-service branch, using state
of the art technologies, the branch would be equipped with a system
Total assets
2003
2004
2005
2006
12.9
44
60
79
*Rs in billion
The State Bank of Pakistan in report earlier said that the unique
distributive and facilitating nature of Islamic banking products can
contribute extensively not only in the development of the economy but
also to the reduction in poverty, unemployment and income inequalities.
Products based on profit and loss sharing with emphasis on financing
production and not consumption, can have a favorable impact on savings
and investments. If operated efficiently and transparently. In this respect,
Musharaka can especially be used in short, medium and long term project
financing, import and pre-shipment export financing and working capital
requirements.
Islamic financial services in Pakistan, a relatively recent
occurrence, have recorded a noteworthy progress during the last three
years, constituting an asset base of Rs 57.1 billion and deposits of over Rs.
37.6 billion as of September 2005. Given its nascent stage of development,
the share of the Islamic Banking industry in the total assets of the banking
sector grew from 0.5 percent in 1996 to 1.7 percent as of September 2005.
However, given the rapid growth of this industry, it is expected that this
share would grow considerably in the years to come.
Rationale
The essential feature of Islamic banking is that it is interestfree. Although it is often claimed that there is more to Islamic banking,
such as contributions towards a more equitable distribution of income and
must be returned by its like (mithl): 'gold for gold, silver for silver, wheat
for wheat, barley for barley, dates for dates, salt for salt, like for like, equal
for equal, and hand to hand ...'.3
The bottom line is that Muslims need no 'proofs' before they
reject the institution of interest: no human explanation for a divine
injunction is necessary for them to accept a dictum, as they recognize the
limits to human reasoning. No human mind can comprehend a divine
order; therefore it is a matter of faith (iman).
The Islamic ban on interest does not mean that capital is
costless in an Islamic system. Islam recognizes capital as a factor of
production but it does not allow the factor to make a prior or predetermined claim on the productive surplus in the form of interest. This
obviously poses the question as to what will then replace the interest rate
mechanism in an Islamic framework. There have been suggestions that
profit-sharing can be a viable alternative (Kahf l982a and l982b).
In Islam, the owner of capital can legitimately share the profits
made by the entrepreneur. What makes profit- sharing permissible in
Islam, while interest is not, is that in the case of the former it is only the
profit-sharing ratio, not the rate of return itself that is predetermined.
It has been argued that profit-sharing can help allocate
resources efficiently, as the profit-sharing ratio can be influenced by
market forces so that capital will flow into those sectors which offer the
highest profit- sharing ratio to the investor, other things being equal. One
dissenting view is that the substitution of profit-sharing for interest as a
resource allocating mechanism is crude and imperfect and that the
institution of interest should therefore be retained as a necessary evil
(Naqvi l982).
However, mainstream Islamic thinking on this subject clearly
points to the need to replace interest with something else, although there is
no clear consensus on what form the alternative to the interest rate
mechanism should take. The issue is not resolved and the search for an
Chapter 2
Abolition of Riba is really a very challenging task. For the first
time in the modern world Muslim countries have undertaken to abolish
Riba. Since there exists no experience in Islamic banking in the modern
financial system there would surely arise some myths and misgivings
about its viability and practicality. A research of these myths and
misgivings can really contribute constructively to the solution of the
problems with which we face in the elimination of Riba. I have taken these
myths and misgivings in the spirit in which they have been expressed and
try to make whether I can make some clarification about these myths and
misgivings which might really take us towards our objective.
Now with that I would start with the myths and misgivings
which have been expressed in various ways.
Clarification:
For the clarification of this misgiving it is proposed to discuss
the true nature and meaning of Riba, usury and interest, so that we can
understand and ascertain whether interest comes within the purview of
Riba as stipulated in Shariah.
Historical Background
Even prior to the dawn of Islam, over 1400 years ago, the
majority of ancient philosophers and almost all the religions of the world
had prohibited money lending as a business; Riba, interest or usury. If one
goes back into history, as far as one can, it would be found that lending
and borrowing as a transaction between members of a society was started
as a commercial operation after the switching over from the barter system
to the money system. Money lending with the earning motive became a
common phenomenon in most of the societies of the world, but people
engaged in this business were generally not regarded respectable during
any period of history.
The doctrine of famous Greek philosopher Aristotle was, that a
piece of money cannot beget another piece, as the sole natural object of
the use of money was to facilitate exchange and that money cannot be
used as a source of accumulating money at interest. Aristotle, therefore,
rejected interest on the basis that money is sterile and accordingly
compared money to a barren hen, which lays no eggs. Plato too
condemned interest. In the early years, the Roman Empire had also
prohibited earnings on money lending.
In Biblical times, all payments for the use of money were
forbidden. Earlier in 340 B.C., Lex Genucia prohibited interest in the
Republic of Rome. When the Roman Empire was Christianized in the
Fourth Century, the Church forbade the clergy from taking interest. In the
early middle ages, Popes and Councils continued to oppose all forms of
payments for the use of money lent, as the money was mainly for the
purpose of exchange and its principal use was its consumption, whereby it
was sunk in exchange. In those days, governments introduced laws to
prohibit charges for use of money. In AD 1311, Pope Clement V made the
prohibition of usury absolute and declared all legislations in favor of usury
as null and void. The teachings of Jesus on the subject are very clear
Love your enemies and do good, Lend, expect nothing in return. The
charging of interest has also been prohibited in Judaism. It says, If you
lend money to any of my people who is poor, you shall be to him creditor,
and you shall not extract interest from him.
It is interesting to note that in AD 605; just before the dawn of
Islam, on a tempestuous day, a spark of fire caught the curtains of Kaba
(House of God in Makkah) resulting in serious damages to the building.
For the repair and reconstruction of the building, contributions were asked
from the general public living in the locality. It was, however, solemnly
announced that for the Holy Building, only pure, clean and honestly
earned money should be donated; prostitutes and usurious people were
specifically debarred from contributing anything. It is, therefore, obvious
that even among the pagans of Arabia, in the dark days of civilization
usury and interest was considered to be the money earned by unethical
means.
The end of thirteenth century saw the decline of the influence
of Orthodox Church and the rise of secular powers. As a consequence, the
charging of interest, which was forbidden by the Church gradually, started
being tolerated. In the Mercantile Era
used on a large scale for commercial transactions and assumed the role of
a factor of production like land and interest on capital was equated to t he
payment for renting of money, similar to the rent of land.
In 1740, the city of Verona, issued a bond at 4% interest, which
led to a lot of controversies. The Benadict XIV wrote to the Bishop of
Italy, firmly emphasizing that it was a sin to take profit beyond the
principal amount given as loan. He specifically condemned various pleas
such as profit on loan was moderate or that the loan was given to rich
person or that it was to be used for production purposes.
In this connection, it is significant to note that after the
establishment of political supremacy of Islam over a greater part of the
world, the prohibition of usury or interest, which was also considered as
undesirable among non-Muslims, was enforced more strictly. The
call for the supply of savings and deposits, and for the mobilization of
deposits by the banking system and
ii.
already mentioned, some of the empirical studies do show that while the
rate of interest is not the main determinant of savings. We can admit that
the rate of interest has a positive influence on savings. Secondly we can
also admit that interest does perform some sort of alloactive function,
particularly in market based economy. But my proposition is that even
though interest might be a factor both in the savings decisions and the
investment decisions, existence of interest is not by itself an unavoidable
necessity for the performance of these two functions. These two functions,
that is, the function of mobilization of savings and the function of
allocation of resources can be performed equally well, and perhaps even
better, under the Islamic banking without interest.
When we talk about the abolition of interest, the idea is not
merely to abolish interest but to replace interest by an alternative system.
Now it depends what kind of alternative system will take but I think it is
generally agreed that it will not be a zero interest banking in the sense that
there will be no return on savings and that person who secure financial
assistance from the banks will not have to give anything to the banks.
The banking so far shows that almost every one who has
studied this problem has come to the conclusion that in the alternative
system there will have to be a system whereby people who put their
deposits in the banking system will get some return but this return will not
be interest because it will not have the attributes which are there in interest
i.e. fixed return and return irrespective of risk of gain and loss. It will be a
variable return and the depositor will share both in gains and losses. So for
those who believe that savings is a function of the rate interest, or the rate
of interest is important. For it helps to mobilize deposits and savings , my
answer is that in the alternate system there will be a return on savings and
there will be a return on bank deposits so the savings decisions, if they are
influenced by the rate of interest , will continue to get incentives for
savings . Similarly, as far as the allocative role of interest is concerned in
the alternate system we have to formulate ways in which these alloctive
functions will be performed and if you have a system of profit sharing in
the banks, one can easily see that by prescribing different profit sharing
ratios, you can influence the allocation of resources. Suppose if we take
the example of two sectors. In one sector the banks decide that they will
give financial assistance only if the parties are prepared to share 80% of
their profits with them, while in another sector they are prepared to
participate if the party gives them only 20%. One can easily see that this
will have an allocative effect. It will discourage the securing of assistance
from commercial banks in those cases where the banks are participating to
the extent of 80%and people educed to put in more of their own resources
or they will go in for those lines of activity where banks are taking a
comparatively smaller part of the share of the profit.
Basic rules are: 1. The subject of sale must exist at the time of sale.
2.
this arrangement the bank discloses its cost in profit margin to the client.
In other words rather than advancing money to a barrower, which is how
the system would work in a conventional banking agreement, the bank
will buy the goods from a third party and sale those goods to the customer
for a pre agreed price.
Murabaha is a mode of financing as old as Musharaka. Today
in Islamic banks world over 66% of all investment transaction are through
Murabaha.
1) The subject of sale must exists at the time of sale. Thus any
thing that may not exist at the time of sale cannot be sold and its non
existence makes the contract void.
2) The subject matter should be in the ownership of the seller
at the time of sale. If he sells something that he has not acquired himself
then the sale becomes void.
3) The subject of sale must be in physical or constructive
possession of the seller when he sells it to another person. Constructive
possession means a situation where the possessor has not taken physical
delivery of the commodity, yet it has come into his control and all rights
and liabilities of the commodity are passed onto him including the risk of
its destruction.
4) The sale must be instant and absolute. Thus a sale attributed
to a future date or a sale contingent on a future event is void.
5) The subject matter should be a property having value. Thus
a good having no value cannot be sold or purchased.
6) The subject of sale should not be a thing used for an unIslamic purpose.
7) The subject of sale must be specifically known and
identified to the buyer.
8) The delivery of the sold commodity to the buyer must be
certain and should not depend on a contingency or chance
.
ISSUES IN MURABAHA:
Following are some of the issues in Murabaha financing:
1) securities against Murabaha
Payments coming from the sale are receivables and for this, the
client may be asked to furnish a security. It can in the form of a mortgage
or hypothecation or some kind of lien or charge.
2) Guaranteeing the Murabaha
The seller can ask the client to furnish a third party guarantee.
In case of default on payment the seller may have recourse to the
guarantor who will be liable to pay the amount guaranteed to him. There
are two issues relating to this:
a) The guarantor cant charge a fee from the original client.
The reason being that a person charging of fee for advancing a loan comes
under the definition of Riba.
b) However the guarantor can charge for any documentation
expenses.
3) penalty of default
Another issue with Murabaha is that if the client defaults in
payments of the price of the due date, the price cant be changed nor can
penalty fees be charged.
In order to deal with dishonest clients who default in payment
deliberately, they should be made liable to pay compensation to the
Islamic bank for the loss suffered on account of default. However these
should be made subject to the following conditions:
a) The defaulter may be given a grace period of at-least one
month.
b) If it is proven beyond doubt that the client is defaulting
without valid excuse then compensation can be demanded.
4) Rollover in Murabaha
Murabaha transaction cannot be rollover for a further period as
the old contract ends. It should be understood that Murabaha is not a loan
rather the sale of commodity, which is differed to a specific date. Once this
commodity is sold, its ownership transfers from the bank to the client and
it is therefore no more a property of the seller. Now what the seller can
claim is the only the agreed price and therefore there is no question of
effecting another sale on the same commodity between the same parties.
5) Rebate on Earlier Payments
Sometimes the debtors want to pay early to get discounts.
However in Islam, majority Muslim scholars including the major schools
of thoughts consider this to be un- Islamic. However if the Islamic bank or
financial institutions give somebody a rebate on its own, it is not
objectionable especially if the client is needy.
6) Calculations of cost in Murabaha
The Murabaha can only be effected when the seller and
ascertain the exact cost he has incurred in acquiring the commodity he
wants to sell. If the exact cost cant be ascertained then Murabaha cant
take place in this case the sale will take place as Musawamah i.e. sale
without reference to cost.
7) subject matter of the sale
2. Bai Muajjal
3. SALAM
This mode of financing can be used by the modern banks and
financial institutions especially to finance the agricultural sector. In Salam
the seller undertakes to supply specific goods to the buyer at a future date
in exchange an advanced price fully paid spot. The price is in cash but the
supply of purchase goods is deferred
Purpose of use:
their crops and to feed their family up to the time of harvest. When Allah
declared Riba haram, the farmers could not take usurious loans. Therefore
Holy Prophet (PBUH) allowed them to sell their agricultural products in
advance.
Under Salam, it is allowed for them that they sell the goods in advance so
that after receiving their cash price, they can easily undertake the aforesaid
business. Salam is beneficial to the sellers because he received the price in
advance and it was beneficial to the buyer also because normally the price
in Salam is lower than the price in spot sales. The permissibility of Salam
is and exception to the general rule that prohibits forward sale and
therefore it is subject to strict conditions, which are as follows:
CONDITIONS OF SALAM:
1. It is necessary for the validity of Salam that the buyer
pays the price in full to the seller at the time of affecting the sale. In the
absence of full payment, it will be tantamount to sale of a debt against a
debt which is expressly prohibited by the Holy Prophet (PBUH).
Moreover, the basic wisdom for allowing Salam is to fulfill the instant
need of the seller. If its not paid on full, the basic purpose will not be
achieved.
2. Only those goods can be sold through a Salam contract in
which the quantity and quality can be exactly specified for example
precious stones cant be sold on the basis of Salam because each stone
BENIFITS:
There are two ways of benefiting from the contract of Salam:
1) After purchasing a commodity by way of Salam, the
financial institutions can sell it through a parallel contract of Salam for the
same date of delivery. The period of Salam in the second parallel contract
is shorter and the price is higher than the first contract. The difference
between the two prices shall be the profit earned by the institution. The
shorter the period of Salam, the higher the price and the greater the profit.
In this way institutions can manage their short term financing portfolios.
2) The institutions can obtain a promise to purchase from a
third party. This promise should be unilateral from the expected buyer. The
buyer does not have to pay the price in advance. When the institutions
receive the commodity, it can sell at a pre-determined price to a third party
according to the terms of the promise.
PARALLEL SALAM:
1) In an arrangement of parallel Salam there must be two
difference and independent contract; one where the bank is a buyer and the
other in which it is a seller. The two contracts cant be tied up and
performance of one should not be contingent on the other. For example, if
A has purchased from B 1000 bags of wheat by way of Salam to be
delivered on 31st December, A can contract a parallel Salam with C to
deliver to him 1000 bags of wheat on 31 December. But while contracting
parallel Salam with C, the delivery of wheat to C cant is conditioned
with taking delivery form B. Therefore even if B didnt delivered wheat
on 31 December, A is duty bound to deliver 1000 bags of wheat to C. He
can seek whatever recourse he has against B, but he cant rid himself from
4. ISTISNA
Istisna is a sale transaction where a commodity is transacted
before it comes into existence. It is an order to a manufacturer to
manufacture a specific commodity for the purchaser. The manufacturer
uses its own material to manufacture the required goods.
In Istisna, price must be fixed with consent of all parties
involved. All other necessary specifications of the commodity must also
be fully settled.
CANCELLATION OF CONTRACT:
After giving prior notice, either party can cancel the contract
before manufacturing party has begun its work. Once the work starts, the
contract cant be cancelled unilaterally.
TIME OF DELIVERY:
price of Istisna with his client that allows him to make a reasonable profit
over his cost. The payment of installments by the client, may start right
from the when the contract of Istisna is signed by the parties. In order to
secure the payment of installment, the title deeds of the house or land, or
any other property of the client may be kept by the financer as a security
until the last installment is paid by the client. The financer will be
responsible to strictly conform to the specifications in the agreement for
the construction of the house. The cost of correcting any discrepancy
would have to be borne by him.
Istisna may also be used for similar projects like installation of
an air conditioner plant in the clients factory, building a bridge or a high
way.
The modern BOT (Buy, operate and transfer) agreement may
be formalized through an Istisna agreement as well. So, if the government
wants to build a high way, it may enter into an Istisna contract with the
builder. The price of Istisna may be the right of the builder to operate the
high way and collect tolls for a specific period.
USES OF ISTSNA:
House financing
Factory building
BOT arrangements
5. IJARAH (LEASING)
BASIC RULES
Transferring of usufruct not ownership
In leasing an owner transfers its usufruct to another person for
an agreed period, at an agreed consideration.
Subject of lessee
Should be valuable, identified and quantified
All consumable things cant be leased out
The corpus of the leased property remains in the ownership of
the seller, and only its usufruct is transferred to the lessee. Thus, anything,
which cant be used without consuming, cant be leased out. For example
money, wheat etc
All liabilities of ownership is born by lessor
As the corpus of the leased property remains in the ownership
of the lesser, all the liabilities emerging from the ownership shall be born
by lessor.
Period of lease
The lessee cant use the leased asset for any purpose other than
the purpose specified in the leased agreement. However, if no such
purpose is specified in the agreement, the lessee can use it for what ever
purpose it is used in the normal course.
Lessee as Ameen
throughout the least period in the sense that any harm or loss caused by the
factors beyond the control of the lessee shall be born by the lesser.
leased out, and the rental shall be distributed between all joint owners
according to the proportion of their respective shares in the property.
Determination of Rental
different phases during the least period, provided that the amount of rent
for each phase is specifically agreed upon at the time of affecting lease. If
the rent for a subsequent phase of the lease period has not been determined
or has been left at the option of the lesser, the lease is not valid.
cost incurred in the purchase of the asset bye lessor, as normally done in
financial leases, is not against the rule of Shariah, if both parties agreed to
it, provided that all other conditions of a valid lease prescribed by the
Shariah are fully adhere to.
before the delivering of he asset to lessee, but the amount show collected
by the lesser shall remain with him as on account payment and shall be
adjusted towards the rent after its been due.
index as well. In this case the ceiling in floor rentals can be identified for
validity of lease.
specific,
some
differences
between
the
it from the supplier through his agent, he is liable to pay all the expenses
incurred in the process of its purchased and its import to the country of
lesser for example expenses of freight and customs duty etc.
can take them into consideration while fixing the rentals, but as a matter of
principle, he is liable to bear all these expenses as the owner of the asset.
An agreement to the contrary, as is found in the traditional financial lease,
is not in conformity with Shariah.
Lessee as Ameen/ liabilities of the parties in case of loss to the
asset;
compensate the lesser for the loss caused by such misuse or negligence.
But he cant be compelled to pay the rent of the remaining period.
6. IJARAH WA IQTINA
SUB-LEASE
If the leased asset is used differently by different users, the
lessee cant sub-lease the leased asset except with the expressed
permission of the lessor. If the lessor permits the lessee for sub-leasing, he
may sub-lease it. If the rent claimed from the lessee is equal to or less than
the rent payable to the owner/ original lessor, all the recognized schools of
Islamic jurisprudence are unanimous on the permissibility of the sub-lease.
However, the options are different in case the rent charge from the sublessee is higher than the rent payable to the owner. Imam Shafi and some
other scholars allow it and hold that the sub-lessor may enjoy the surplus
received from the sub-lessee. This is preferred view in the Hanbali School
as well. On the other hand, Imam Abu Hanifah is of the view that the
surplus received from the sub-lessee in this case is not permissible for the
sub-lessor to keep and he will have to give that surplus in charity.
However, if the sub lessor has developed the least property by adding
something to it or has rented it in a currency different forms the currency
in which he himself pays rent to the owner/ the original lessor, he can
claim a higher rent from his sub-lessee and can enjoy the surplus.
Although the view of Imam Abu Hanifah is more precautious
which should be acted upon to the best possible extent, in cases of need
the view of Shafi and Hanbli schools may be followed because there is no
expressed prohibition in the Holy Quran or in the Sunnah against the
Surplus claimed from the lessee. Ibne Qudamah has argued for the
permissibility of surplus on forceful grounds.
7. Muqarada:
Under this technique Islamic bank floats the Islamic bonds to
finance a specific project. The investor who purchase muqarada bonds not
only get a share in the profit of the project being finance but also share the
risks of low profit or even loses. Bondholders have no say in the
management of the project but act as non-voting shareholder.
These above are the Islamic modes of financing through which
an Islamic bank can finance the companies as well as individuals. Even a
system based on the concept of a normal rate of return can be applied in
cases where the accounts are not kept. The central bank of the country or
any other suitable agency can determined what is the normal rate of profit
in particular sectors and the banks can contract on that basis. If the party
pays out that profit no questions are asked, but if it is claimed that less
profit has been made or a loss has been incurred the bank should be
entitled to ask the party to prove his claim and the varsity of this claim
could be judged by an independent agency and on the basis a settlement
could be arrived at. So this is not an insurmountable problem.
Clarification:
Clarification:
But my query to such kind of myth is why should it be so?
There are three kinds of factors which are relevant to the possibilities of
defaults.
1st, to whom finance is provided
2nd, for what purpose the finance is provided
3rd, what type of supervision is exercised by the financial
institutions on the end use of the resources.
Now these elements are essentially the same whether it is an
interest based banking system or it is a system which is based on profit
sharing under Shariah principles. If sufficient care is not exercised in
respect of these three elements defaults are sure to arise and as we know
they do arise in the modern systems even though it is based on interest. In
fact, i feel that a system which is not based on interest will be superior and
the chances of default should be minimized if properly worked. This is
because as compared to the fixed interest system, the banks will be more
closely associated with the end-use of funds. In the fixed interest system
tendency is that the banks are satisfied if they get enough security for the
advances and if they feel that the company has profits enough to cover re
payment of its capital and the amount of interest, they are not concerned
even if the profitability is nil after paying interest to banks. But when they
begin to share in the profit they will be more concerned about the efficient
working of the enterprises and, therefore, from that point of view under
the new system, the defaults should be less rather than more.
Clarification:
Well, this is an argument similar to one which says that since
the banks have short terms liabilities they should not lend on long term
basis because this can create a problem of liquidity. This use to be a
fashionable argument a few decades back but very little really is heard
about that now. For one reason we know that in a number of countries the
liabilities of the banking systems are not pre dominantly sight liabilities. In
fact, in our country Pakistan, we find that about fifty percent of the
liabilities are other than demands liabilities. A part from that, with the
growth of central banking and the concept of what we call shift ability of
assets, the liquidity can be ensured by the central bank which is under no
constraint as it can create any amount of credit in times of need. So it can
come to the assistance of the banking systems in time stress.
So i think one should not exaggerate the difficulties about
liquidity. Moreover, not all the finance that will b provided by the banks
under the Islamic banking systems will be for long terms because when
the whole banking systems switches over to a system which is not based
on interest, banks will be expected to provide both short term finance and
long term finance and therefore, by proper management they should be
able to arrange a cash flow which will be quite adequate to take care of the
demands that may be made on the banking systems for withdrawal of the
deposits. I might also add that if you study the history of grow of banking
in the western countries you will find that before central banks came on
the same and before the system of deposits insurance came into fashion,
there were cases of bank failures in a number of countries.
the banks a certain amount of return irrespective of what profit it earns and
irrespective of the fact that it may incur a loss. But once a concern makes a
profit the system that we envisage will entitle the banks to receive and
agreed share of the profit of that concern. It can thus be seen that capital is
not been provided free to the business concerns. In fact, in the case of
highly profitable undertakings banks may well earn much more under the
profit sharing system than under the fixed interest systems. So it is not
correct to say that capital is been provided free.
However, when the whole system gets going, one can visualize
that while mainly work on the system of profit and loss sharing there can
be some institutional mechanisms whereby some sectors can be provided
finance without any return whatsoever that is without claiming any part of
the profit even if profits are made. But this will have to be a conscious
decision and it will have to be taken in context of socio economic
objectives of a particular country. For example, if the objective of
economic policy is to bring about a certain transfer of resources from one
section of society to another it is perfectly legitimate to have a system
whereby resources of the bank will be provided completely free without
share in the profit of a particular sector or a particular sub sector, while
banks appropriate large parts of profits that might be made in other
sectors, thereby setting up a mechanism of transfer of resources from
certain sectors of high income generation to sectors of low income
generations.
I hope my this Research paper will help in clarifying some of
the issues that have been raised on this very sensitive subject of interest
free banking and that they will provide food fore the further thought.